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NBER WORKING PAPER SERIES
WHAT IS THE BUSINESS OF BUSINESS?
Andreas NilssonDavid T. Robinson
Working Paper 23505http://www.nber.org/papers/w23505
NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue
Cambridge, MA 02138June 2017
The authors are grateful to Josh Lerner, Yasin Ozcan, and Scott Stern for suggestions on the current draft. Hengjie Ai, Ulf Axelson, Paul Bloom, Ronnie Chatterji, Shawn Cole, Ofer Eldar, Rich Mathews, Alex Nichols, Adriano Rampini, Pian Shu, Per Str\"omberg, and seminar participants at the Swedish House of Finance, the Skoll Research Colloquium on Social Entrepreneurship, Duke, MIT, and the Harvard Social Enterprise Conference provided many helpful suggestions on earlier drafts. Special thanks for detailed suggestions and encouragement go to Brian Trelstad, Jean de Bettignies and the late Greg Dees. Much of this work originated when Robinson was the Olof Stenhammar Professor of Financial Entrepreneurship at the Stockholm School of Economics and when Nilsson was a Visiting Fellow at Harvard Business School. The authors are grateful to these institutions for their hospitality. Any errors are ours alone. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.
© 2017 by Andreas Nilsson and David T. Robinson. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.
What is the Business of Business?Andreas Nilsson and David T. RobinsonNBER Working Paper No. 23505June 2017JEL No. G3,G32,G38,H44,M14
ABSTRACT
This paper develops a simple framework for understanding the emergence of new organizational forms, such as socially responsible firms and social entrepreneurs, that embody the private sector's efforts to resolve problems that typically have been within the purview of government and traditional public charities. We consider organizations that can generate both financial and social returns. Differences in the technologies between the for-profit sector and the social sector give rise to comparative advantages and play a key part in the analysis. This allows us to analyze the conditions under which hybrid organizations emerge in place of traditional charities and profit-maximizers.
Andreas NilssonSonanz GmbHFranz-Joseph-Straße 1280801 [email protected]
David T. RobinsonFuqua School of BusinessDuke University100 Fuqua DriveDurham, NC 27708and [email protected]
1 Introduction
In 1970, Milton Friedman famously argued that the only social responsibility of business
was to maximize profits (Friedman, 1970). These profits, if only returned to the firm’s
owners (the shareholders, on whose behalf the management should rightfully act), could
be put to charitable purposes as shareholders saw fit. By essentially delegating the
task of collecting and disbursing taxes to corporate managers, in Friedman’s analysis,
shareholders allowed themselves to unwittingly become pawns in a larger battle to derail
the capitalist system. Levitt (1958) captured this perspective succinctly when he wrote,
“the business of business is profits.”
In the almost half century since Friedman’s admonition, business has evolved along
a trajectory quite contrary to what he advocated. It seems as if the business of business
is more than just business: socially responsible businesses, which pursue hybrid goals of
social good and financial gain, are commonplace. Today it is standard to see for-profit
businesses pursuing double-bottom-line objectives. At the same time, Dees (1998) notes
that nonprofits are increasingly adopting business methods, writing, “Faced with rising
costs, more competition for fewer donations and grants, and increased rivalry from for-
profit companies entering the social sector, nonprofits are turning to the for-profit world
to leverage or replace their traditional sources of funding.” Why has this occurred? Why
have the lines between business and charity become so blurred?
One prominent view for why this has occurred is captured succinctly by Benabou
and Tirole (2010) when they note that, “Society’s demands for individual and corporate
social responsibility as an alternative response to market and distributive failures are
becoming increasingly prominent” (emphasis added). This is the view that increasing
awareness of the social cost of consumer goods, coupled with the difficulty government
actors face when attempting to regulate across global supply chains or otherwise seek
redistributive solutions, has driven the rise in corporate social responsibility (CSR).
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The central goal of this paper is to put forward a different argument, one that centers
on the importance of innovation in business practice. Our argument is that business
model innovations from both charities and for-profit firms give these new hybrid firms
a comparative advantage over traditional organizations in delivering what other non-
market actors provide. The analysis we provide makes it clear that if we were simply
living through a period of evolving preferences for financial and social returns, we would
see increases in pure charity, not changes in business practice. In short, our analysis
argues that the emergence of socially minded business activity must be the result of
technological changes on the supply-side, rather than the result of demand-side changes
in investor or consumer preferences.
But before we dive too far into our analysis, we should take a step back. Clearly,
some aspects of so-called social responsibility need no special explanation. For instance,
hotels frequently encourage guests to hang their towels to be reused rather than washed
each day. While this is often promoted as environmental stewardship, it can be just as
easily understood as an attempt to lower the hotel’s operating costs.
While business activities like this are simply alternative strategies for profit maxi-
mization, there are many examples of firms that either sacrifice profits by operating in a
manner that involves stricter environmental or social guidelines than they are required
by law, or that take a share of their profits and donate them to causes that could easily
be supported by the firm’s shareholders directly. Ben & Jerry’s ice cream and Patago-
nia are two corporations that have historically stressed environmental stewardship, the
latter famous for an advertising campaign admonishing their customers not to buy new
Patagonia jackets when the old ones still had use. The Body Shop, a beauty products
manufacturer and retailer, works to end animal testing of cosmetics, and in so doing
presumably embraces higher production costs than they might otherwise face. Tyson
Foods provides grants to organizations that abate child hunger. Molson Coors invests
in education to promote responsible drinking behavior. Many law firms and consulting
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firms encourage their employees to offer their time on a pro bono basis to important
causes in their community. Of course, any of these strategies can be viewed cynically
as a marketing ploy, and indeed many observers tout these firms as providing examples
of successful CSR strategies precisely because their CSR strategies align well with their
core corporate mission. But the fact remains, as Friedman pointed out, that consumers
and investors could carry out these charitable acts on their own account. Moreover, as
we discuss in Section 2, the evidence is far from persuasive that firms are acting in their
shareholders’ best interests by engaging in these activities. Why, then, do firms behave
this way? Or put differently, how does this behavior survive the forces of competition
in the market?
At the same time, many organizations that would traditionally be labelled as ‘non-
profits’ adopt a hybrid approach that blends the pursuit of profit with charitable purpose.
Take the example of VisionSpring, an organization that promotes vision correction in
the developing world by distributing eyeglasses. While they rely on a combination of
philanthropic support as well as strategic partnerships with eyeglass retailers like Warby-
Parker, they also distribute eyeglasses at a profit through a variety of channels. One is
a model in which local merchants who have been trained to diagnose and correct simple
vision problems sell glasses at a modest profit in the communities in which they live.
Another is retail outlets in local clinics and hospitals. Why do they blend the pursuit
of profit with charitable purpose instead of operating like a pure charity?
One reason these questions persist is that we lack a widely accepted framework for
thinking about mixing charity and business. Thus, to explore these questions, this
paper develops a simple graphical framework for understanding the emergence of new
organizational forms that blend profit and stewardship. For us, Friedman’s analysis is
not just a convenient rhetorical straw man: the intuition that we develop hinges critically
on a central theme in Friedman’s analysis, which is that idea that investors always have
the ability to take “ill-gotten” profits and put them to work for social aims of their own
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desire. Put differently, Friedman’s central observation is that we do not need to delegate
the task of impact investing to either a firm or an intermediary–any of us can act as an
impact investor by taking returns we have earned and directing them towards charities
of our own choosing. This observation is the fundamental building block of a simple
framework for how to think about the emergence of socially conscious business activity.
We start by assuming that investors have preferences over financial returns as well as
social returns. That is, investors not only want to invest in profit-making enterprises, but
they also place monetary value on social goods such as increased literacy in a developing
country or better environmental stewardship. While many environmental, social or
governance objectives—a clean environment, good working conditions, etc.—have the
flavor of public goods, nothing in our analysis hinges on the existence of externalities.
In other words, we do not assume that markets are broken in order to create a motivation
for CSR.
We assume that for-profit corporations can choose to operate in a socially minded
fashion in addition to simply maximizing profits, and that charities can make operational
choices that sacrifice charitable output to stave off financial losses. Because we are
concerned with understanding the tradeoffs between social and financial output, we
assume that all win-win opportunities, such as hotels “going green” by encouraging
guests to hang up their towels, have already been exhausted. Instead, we focus only on
situations in which achieving social goals comes at the expense of profits.
This framework allows us to explore the interplay between for-profit corporations that
can engage in CSR, charities that can incorporate profit motives into their operations,
and investors who allocate resources between profit-making and charity. The mechanics
of our framework are exactly what Friedman imagined: investors can choose to allocate
their own wealth between social and financial returns, and therefore do not necessarily
need corporations to act charitably. The question we ask is whether, and under what
conditions, investors will ask corporations to operate with an eye towards social good
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even though these same investors are perfectly capable of acting charitably on their own
account. In other words, we ask “What is the business of business?”
The key insight of our analysis is that the optimality of Friedman’s prescription
hinges critically on the relative tradeoffs that investors and organizations face when
they substitute between charity and profit. By relative, we refer to the fact that busi-
nesses, charities and investors each have the ability to make tradeoffs between financial
and social output; to maximize overall output the tradeoff should therefore be left to the
set of actors who do it most efficiently. The fact that shareholders can take profits and
redistribute them to pure charities does not necessarily compel organizations to avoid a
dual purpose; instead, it imposes constraints on them by establishing a minimum level
above which organizations must trade off social and financial output. When the tradeoff
between social and financial returns is sufficiently favorable inside for-profit corporations,
competition for investment dollars requires for-profit corporations to produce below the
maximal level of financial return and instead produce a blend of social and financial
returns. In our analysis, this corresponds to the emergence of corporate social respon-
sibility. Similarly, when the tradeoff is sufficiently favorable inside charities, they are
optimally required to pursue twin goals of social and financial return. This corresponds
to the emergence of social entrepreneurship.
When the tradeoffs between social and financial returns are sufficiently weak within
both the corporate and the social sectors, investors drive the provision of social goods by
allocating wealth between two extreme technologies: a pure charity and a pure profit-
maximizing technology. This describes exactly the situation prescribed by Milton Fried-
man and Theodore Levitt in their admonition against corporate social responsibility.
However, whenever the tradeoffs between social and financial returns inside both types
of organizations are favorable, this investment rule is no longer optimal and investors will
allocate their capital between a socially responsible profit-making firm and a “financially
savvy” charity.
5
Although our analysis is intentionally stark, it sharpens our understanding of several
open questions in this area. First, whether investors push firms to be “pure-play” profit
maximizers or socially minded hybrid businesses depends not on society’s preferences
over the amount of social and financial profit that holds in the aggregate, but rather in
the technological implications of the business models that organizations operate. The
flip side of this observation is that business model innovations that have the potential to
be more CSR-friendly need not result in more social output in the aggregate, just better
tradeoffs.
Our analysis also offers a guide for thinking about which types of CSR activities
firms should engage in. Here, the logic is simple. For CSR to survive the forces it
competition, it is not necessary that CSR increases a firm’s bottom line. But it must be
the case that the organization can exploit opportunities that its investors cannot. This
would be the case, for example, if information asymmetries created complementarities
between financial and social returns that were visible to the corporate manager but not
to outsiders. This naturally suggests that firms should engage in CSR programs that
involve the highest degree of complementarity with their core business.
A number of other academic studies also work to develop frameworks for thinking
about tradeoffs between alternative mechanisms for providing socially valuable goods.
Kotchen (2006) develops a general model of private provision of a public good where
investors have preferences over social welfare and private consumption and maximize
utility by allocating wealth across three investment opportunities: a pure private good
(e.g., coffee), a pure public good (e.g., environmental quality) and a hybrid, “green”
good—an example might be environmentally friendly, shade-grown coffee. His model
shows that green goods can either increase or decrease private provision of the asso-
ciated environmental public good, depending heavily on whether the public good is a
complement to or substitute for private consumption. Small and Graff Zivin (2005) and
Baron (2007) also develop models in which investors can give directly to charities or
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invest in firms that engage in CSR and focus on the degree to which one activity crowds
out another.
The remainder of the paper is organized as follows. To set the stage for our theoretical
discussion, we begin in Section 2 with a brief overview of the evidence linking CSR and
value creation. We lay out the basics of our framework in Section 3, and provide an
analysis in Section 4. Section 5 discusses some potential shortcomings and challenges
that our framework must confront, while Section 6 explores implications for innovation
policy at various levels. Section 7 concludes.
2 Can Firms Do Well by Doing Good?
Because the business case for CSR often centers around the claim that businesses can
do well financially by doing social good, we begin by reviewing some of the recent
evidence on the value implications of CSR. This is not intended to be an exhaustive
survey, but rather to set the stage for our theoretical analysis with a discussion of the
key empirical issues. Kitzmueller and Shimshack (2012) and Benabou and Tirole (2010)
provide excellent reviews of the role of the business sector in producing social outputs.
2.1 CSR and Corporate Profits
Like the example of the hotel from Section 1, many firms engage in social activities for
the purpose of increasing the bottom line. This can either take the form of environmental
or social stewardship activities that result in cost reductions, or stewardship activities
that stimulate demand.
This motive has received significant attention by academic scholars. Numerous pa-
pers try to estimate the effect of corporate social responsibility on financial performance,
but the evidence of different business practices is mixed. There is clear evidence that
7
employees are willing to sacrifice wages to work at companies that engage in social re-
sponsibility. Frank (2004), for example, uses survey evidence from Cornell graduates
to point to a compensating salary differential for corporate social responsibility. The
more recent work of Nyborg and Zhang (2013) shows that firms with a strong reputation
for social responsibility pay 38% less than firms with a weak reputation for CSR. This
difference drops to about 24% when one accounts for industry and gender/demographic
composition of the work force. Finally, in a compelling new study using natural field
experiments, Burbano (2016) identifies a negative causal effect of receiving information
about an employer’s social responsibility on prospective workers wage requirements for
a job. Indeed she finds that a 44% decrease in the wage bids submitted by workers after
learning about the employer’s CSR activity.
In a similar vein, Edmans (2010) finds that companies recognized in the “Top 100
Places to Work” in terms of how they treat their employees earn risk-adjusted rates of
return that are 4% per annum higher than other, non-friendly companies. Recent work
by Bloom et al. (2010) shows that better-managed firms are not only more productive,
but they also have a smaller carbon footprint.
On the other hand, Hong and Kacperczyk (2009) finds that companies involved
in the production of alcohol, tobacco and gaming have higher expected returns than
otherwise comparable stocks, suggesting that investors pay a financial price for a higher
social return. A meta-study by Margolis et al. (2007) covering 167 papers concludes
that corporate social responsibility has a small, positive effect on financial performance.
However, Margolis et al. (2007) point out that many papers in their study struggle to
overcome the inherent endogeneity bias that exists in studies of this nature. In other
words, it is difficult to distinguish between firms that do well financially because they do
good socially and firms that are able to do good socially because they do well financially.
CSR may not only operate by affecting labor or product costs, it may also help
to attract customers who identify with certain causes. Heal (2008) offers numerous
8
examples of firms that witness soaring profits by taking poorly selling products, and
rebranding them in a manner that promotes a social cause. One such example is the
Calphalon Corporation—makers of high-end cookware—who co-branded a poorly selling
pan with the Share Our Strength, a national anti-hunger campaign, donating $5 from
every pan sale to the charity. According to Heal (2008), sales of the pan increased by
250 per cent.
Fisman et al. (2006) develops a signaling model in which CSR may serve as a means
of vertical differentiation in a market where quality is difficult to observe. In their
analysis, there is no complementarity between between the production of a good and
the provision of CSR. Instead, entrepreneurs can be of one of two types: either purely
profit minded or socially minded. For the latter group, it is less costly to adhere to a
CSR agenda, even if the focus of the CSR is completely uncorrelated with the firm’s
core activity. Thus, the CSR activity provides a signal to discerning customers who are
interested in high quality products.
The idea of the paper can be illustrated with the following example, which they
provide. Consider a consumer who is interested in buying hormone free beef. They
may be motivated by personal health motives or animal husbandry considerations, but
in either case they find it virtually impossible, even after consuming the product, to
verify the absence of bovine growth hormones. This creates an incentive for a socially
minded grocery chain, or meat brand, to establish its trustworthiness in the eyes of its
customers. This encourages the chain to engage in CSR expenditures which are visible
to the consumer, even if they are unrelated to the firm’s products, because they provide
useful signals of the firm’s trustworthiness in providing unobservable quality.
In empirical work, the authors find that the link between profitability and CSR
activity is stronger in advertising-intensive industries, and in settings where competition
is more intense. This not only supports the model but illustrates that the link between
profits and CSR activity depends heavily on the industry setting in which it is occurring.
9
2.2 CSR as a Strategic Asset
Even if CSR initiatives do not immediately affect a firm’s profitability through higher
product revenues or lower costs, there are other reasons why it might increase value.
Corporate social responsibility can also be a strategic asset that firms use to build a
reputation with key stakeholders. Godfrey (2005) first proposed the idea that firms
invest in CSR in order to purchase a form of ‘insurance’ against negative firm events.
The idea in Godfrey (2005) is that by engaging in CSR, firms create a reputation for
behaving with regard to other actors, and that this forms a “moral capital” that the
firm can draw upon in times of adversity. Godfrey, Merrill and Hansen (2009) test this
idea by relating stock price reactions associated with negative legal or regulatory actions
to measures of CSR activity and engagement and find that high CSR scores erase 1/2
to 3/4 of the overall negative stock price effect associated with the negative shock.
Relatedly, Kotchen and Moon (2011) provide an empirical investigation of the hy-
pothesis that companies engage in CSR in order to offset corporate social irresponsibility.
Using data from KLD Research & Analytics, a firm that specializes in collecting data
related to compliance with environmental, social and governance objectives, they find
general support that companies which do more “harm” also do more “good”. In par-
ticular, they find that firms that score poorly in terms of being “harmful” in a social
dimension also generate more “good” in that same category (the results are significant
for community relations, environment, and human rights). One way of interpreting this
result is that firms are better placed to offset negative influences they have on a social
issue through its production by generating social output relating to the same issue.
Minor and Morgan (2013) offer a closely related perspective, which is that firms use
CSR so that market participants will give the firm the “benefit of the doubt” in the
event of a corporate disaster—for example, an oil spill or a chemical factory explosion.
The idea in Minor and Morgan (2013) is that any adverse business event could be due
to some combination of bad luck and managerial negligence. Investors and other market
10
participants place weight on each of these explanations, and update their beliefs about
negligence in the wake of the corporate disaster. CSR initiatives shape the opinions of
outsiders, causing them to believe that firms are more conscientious, which in turn causes
observers to place more weight on bad luck, as opposed to managerial incompetence, as
the reason for the disaster.
Minor (2015) builds on these arguments with evidence that certain types of CSR
activities protect firm value in the case of adverse events, while other types do not.
When firms engage in CSR activities that are related to the negative event, the firms
are punished less by market participants, amounting to an average of about $1 billion
less loss in market value. In contrast, when the CSR activities are disconnected from
the business activity associated with the event, there is no preservation of market value,
and indeed markets punish these firms even more than those with no CSR initiatives.
Another perspective on CSR as a strategic asset is provided by de Bettiginies and
Robinson (2017), who study the interaction of a firm, a government, and a citizenry,
some of whom have preferences for CSR activities. They assume that firms unavoid-
ably generate negative spillovers in the pursuit of profits. In their baseline analysis,
governments maximize social welfare by setting regulatory thresholds, such as pollution
limits or mandatory labor practices. Because governments optimally balance profits
against spillovers in the baseline, there is no scope for CSR to emerge, because firms
could never improve social welfare by deviating from the threshold. But the analysis
changes completely when frictions are introduced that affect the government’s ability to
set thresholds optimally. When this occurs, firms can benefit by engaging in CSR: they
extract surplus from CSR-minded individuals (for example, in the form of lower wages)
who wish to see better social outcomes than those provided through regulation. A dark
side to CSR can emerge in certain circumstances: in the extreme, when the frictions are
strong enough, firms may act strategically to cause distortions to be greater than they
would otherwise be in order to capture greater surplus from CSR-minded citizens. There
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analysis stresses the difficulty of conducting welfare analysis based on the observed CSR
outcomes, and also helps to rationalize seemingly conflicting empirical findings by nest-
ing many results as special cases based on whether the firm’s rent extraction is passed
along to shareholders or trapped inside the firm through managerial agency.
2.3 CSR as a Managerial Agency Problem
The flip side of the argument that firms increase shareholder value by engaging in CSR is
that CSR is instead another form of managerial agency. Under this motive, CSR is a form
of rent extraction by corporate managers who invest in pet projects of charitable nature.
Even though the charitable output of the pet projects may be valuable for society, it
constitutes managerial agency because either (a) it works against the preferences of
shareholders, in whose interests the managers should act, or (b), it is wasteful in the
sense that it does not represent the lowest cost way of achieving the social good it aims
to achieve. For example, if $100 of shareholder value are destroyed to create a $50
improvement in a manager’s passionate social cause, then many would argue that value
has been destroyed even if all are in agreement that the social cause is worthy.
Cheng, Hong and Shue (2012) explore the agency motive empirically with two sets
of tests, both of which zero in on shocks to the level of managerial entrenchment. First,
they use the 2003 Dividend Tax Cut as a shock to managerial ownership and finds that
this had a negative effect on CSR spending. The idea here is that the dividend tax cut
effectively increased the sensitivity of a manager’s financial payoff to her firm’s under-
lying value. By showing that increasing the sensitivity of pay to financial performance
decreases CSR spending, the authors argue that CSR spending on the margin is an
artifact of managerial agency problems.
The second test studies the effects of an exogenous change in firm governance by
using discontinuities that arise in the context of close voting outcomes. Using proxy
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contests regarding shareholder-initiated governance proposals, they find that firms in
which shareholder proposals narrowly pass experience much slower growth in CSR than
firms in which the proposals narrowly fail. The idea here is that by comparing narrow
passes to narrow failures, firms that are otherwise equal face different corporate gover-
nance regimes. The fact that the more restrictive regime results in less CSR spending
demonstrates that CSR spending itself is on the margin higher in settings with more lax
governance, which in turn is further evidence that it is a symptom of managerial agency
problems.
3 A Framework for Analyzing Hybrid Organizations
Our presentation proceeds in three steps. First, we lay out the basic economic environ-
ment in terms of what types of economic actors are involved in our analysis and what
types of economic outputs they care about. Next, we discuss the key technological as-
sumptions behind the tradeoffs that we study in the paper. Finally, we discuss the role
of consumers or investors in greater detail.
3.1 Actors and Outputs
The economic environment we consider centers around the production of two types of
output: financial output, F , and social output, S. Financial output is simply money–
this requires no special explanation. Social returns can be thought as non-pecuniary
returns accruing to the investor such as increased literacy in a developing country or
increased biodiversity. The precise nature of S may vary from setting to setting. At this
point in the analysis, we are intentionally vague about the specifics of S, and later in
the discussion we will return to some challenges associated with enumerating S in terms
that investors can quantify.
13
Three types of economic actors interact with one another to determine the amount
of F and S produced, as well as the manner in which it is produced. These are for-profit
businesses, charities, and investors. Businesses naturally generate operating profits, or
financial returns, F , but can sacrifice these to generate social output, S. Charities
naturally generate social returns, S, but can sacrifice these to generate F . Charities and
businesses need capital from investor in order to operate.
Although our analysis does not require specific assumptions about the operating
structure or legal organization of charities and businesses, it is useful for fixing ideas to
offer some specifics around organizational design. For charities, it is useful to think of
them as operating with a loss but relying on endowment income to subsidize these losses.
For firms, it is customary to think of them as being operated for the benefit of their
equity owners, who provide capital to the firm in exchange for shares. It is also possible
to think of firms as operating from the profits associated with selling their goods in the
market. In that sense, it is possible to think of capital as provided by interchangeably
by investors, consumers or citizens.
3.2 Business models for Businesses and Charities
A key element in our analysis is that the idea of a business model. A business model is
not a final production decision–it is not a choice of a particular level of F and S–but
rather a description of the technological tradeoffs involved by an organization. This is
a simple way to capture the idea that businesses and charities have different objectives,
and combine resources in different ways to achieve these objectives. Business models
can differ from one another both within and across types of organizations.
In terms of the difference between a business and a charity, we can imagine that
either type of organization is capable of generating F or S, but with varying degrees of
efficiency. Businesses are naturally better at making financial returns, but can sacrifice
14
financial returns to generate social output. Charities are naturally better at making
social returns, but can sacrifice these to generate more financial output. In other words,
in a horse race to produce pure financial profit, the business will win, while in a horse
race to produce pure social output, the charity will win.
There are also differences within each type of organization in terms of the nature
of the business models they operate. This is captured in Figure 1, which depicts three
different potential business models for charities. Each line represents the feasible set of
social and financial returns that can be achieved.
Figure 1 about here
Each of the business models depicted in Figure 1 involves a different set of tradeoffs be-
tween social and financial output. For instance, the business model labeled “1” involves
a constant tradeoff between social and financial output. The slope of the straight line
for 1 describes the rate at which social output is sacrificed when additional profits are
obtained. Comparing business models 1 and 2, it is clear that business model 2 is strictly
superior: although both business models involve constant tradeoffs, business model 2
trades off financial and social output at a more favorable rate than does business model
1. Anything business model 1 can do, business model 2 can do better.
In comparison, business model 3 initially involves relatively favorable tradeoffs be-
tween social output and financial output than either 1 or 2. The fact that the curve
representing business model 3 is initially very flat implies that a charity operating this
business model sacrifices very little social output to generate initial financial output.
Then as their search for more financial output increases, it grows more difficult, and the
tradeoff becomes less favorable.
Moving along any of these lines from a “pure-S” business strategy to a mixed (S, F )
business strategy represents the commercialization of non-profits. Dees (1998) notes that
15
nonprofits are increasingly adopting business methods. These activities range from sup-
plementary revenue-generating activities to a commercialization of the core programs
through which they accomplish their missions. The sacrifice of S implied by moving
along any of these lines reflects the concern in Weisbrod (1998) that increased commer-
cialization leads to reduced social output, because it may distract management attention
or cause a deviation from the organization’s mission, i.e. its social output.
The business models 4, 5, and 6 are similar in spirit to what have been described
above, but reflect the tradeoffs faced by businesses, which are naturally better at gen-
erating financial output but can generate social output by sacrificing financial returns.
Business model 5 dominates business model 4, in that more social output can be achieved
per unit of financial sacrifice, even though both business models involve constant trade-
offs between S and F . Like model 3, model 6 displays decreasing returns to the “non-
core” activity, even though low values of S can be achieved with much more favorable
tradeoffs than available through either model 4 or 5.
One example of these tradeoffs might be corporate philanthropy, in which managers
shift resources towards increasing social output on behalf of approving shareholders.
Having a corporate manager act on behalf of a large group of like-minded shareholders
interested in transferring money to a social cause may be an efficient way to overcome
burdensome transactions costs otherwise associated with each shareholder acting indi-
vidually. Alternatively, these tradeoffs might naturally arise is if social and financial
output are connected through some fundamental technological aspect of production.
For example, financial returns might be generated through natural resource extraction
while social returns might represent environmental quality. In such a case, the business
owner would be a mining company and the charity would be an organization devoted
to environmental stewardship. Or the business might be a retail goods manufacturer,
in which case the social output might be related to labor standards, like whether child
labor is prevalent or whether workers are paid a living wage.
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3.3 Investors
Investors are agents with financial capital who have preferences over social and financial
output. They take the existing business models as given, and allocate capital in order to
maximize their utility. Depending on their preferences, they could give all their capital
to a charity, all of it to a business, or they could mix between the two. Because our goal
is to reflect broad tradeoffs in society, it is perhaps most natural to think of the investor
in this analysis as an aggregation of many small investors.
In theory, investors could be ordinary citizens in the spirit implied by Friedman’s
analysis, but in practice, investors may take many forms. Many institutional investors
are charitable foundations, university endowments, or family investment offices, and
these investors often have their own views on social responsibility in terms of the social
issues that the organization supports. Many private charitable foundations operate with
a clear orientation towards certain social goals and also manage large pools of investment
capital that provide operating income for the foundation. For example, the Kresge Foun-
dation, founded by the founder of the Kmart Corporation, is a $3.6 billion endowment
that specifically works to serve low-income and vulnerable populations, especially in the
Detroit area, where Kmart first began. The William and Flora Hewlett Foundation has
the environment as one of its key focus areas. In both examples, it is natural to think
that their investment strategies will be guided in part by the desire to maximize financial
returns, but also by the desire to pursue philanthropic goals. Alternatively, investors
could be private equity or venture capital funds, in which case their investment choices
may reflect the underlying preferences of their limited partners, many of whom will be
exactly the types of foundations, pensions and endowments described above.
To keep the analysis as simple as possible, we will assume that there are no manage-
rial agency or corporate governance problems that, given a particular business model,
prevent investors from contracting with businesses and charities over the exact manner in
which they operate their business model. In other words, investors observe the business
17
models that charities and businesses operate and can direct both types of organizations
to produce certain pairs of (F ,S) given the business models they have available to them.
4 Analyzing the Framework
4.1 The World of Friedman and Levitt
The central message of Friedman (1970) and Levitt (1958) is that the socially optimal
investment strategy is to allocate wealth between a purely profit-maximizing firm and
a purely social-output maximizing charity. They argue that this dominates alternatives
that involve hybrid firms. This rule allows an investor to achieve a continuum of return
combinations on her own simply by creating a portfolio of the profit-maximizing firm
and a pure charity. Figure 2 provides an illustration of this logic.
Figure 2 about here
In Figure 2, we have assumed that both charities and businesses operate business models
that involve constant tradeoffs between social and financial output. In such a world, it is
optimal for the investor both to direct the charity to ignore financial considerations and
maximize charitable output, and at the same time, direct the business to ignore social
output and maximize profits. In so doing, this allows the investor to choose any point
along the dashed line connecting the two extremes.
Based on the tradeoffs depicted in Figure 2, the investment strategy prescribed by
Friedman and Levitt is indeed the strategy that maximizes the social output for a given
amount of financial output. Regardless of the amount of S that is optimal from a social
standpoint, the best way to organize the production of S and F is through pure charity
and pure profit maximization.
18
Note that this logic involves two decisions on the part of the investor. The first is
how to operate each business model—in this case, instructing each type of organization
to focus on a “pure-play” strategy. This decision is the same no matter what are the
investor’s (or by extension, society’s) preferences for the amount of social output–it is
driven purely by the technology implied by each business model. The second decision
is whether to have more social output and less profits, or more profits and less social
output. This example helps to illustrate why it cannot be the case that the rise of CSR is
simply a reflection of increased preferences for charitable output. If it were only this, we
would see movement along the “Friedman Line” in a manner consistent with producing
more S and less F , but we would not necessarily see charities and companies deviating
from their production plans given the business models they operated.
To see this more clearly, Figure 2 describes two possible allocations based on different
investor preferences. These are denoted with the two X’s along the Friedman/Levitt line.
These represent a high social output allocation and a low social output allocation. Figure
2 illustrates how changes in social preferences can result in greater levels of S even if no
commensurate change in business models occurs.
4.2 A Double Bottom Line World
The main message of our analysis is that the welfare prescriptions described in Figure 2
need not always hold. Critically, this depends on the tradeoffs implicit in the business
and charity business models and how they compare to an investor’s ability to form
portfolios of charities and businesses on their own account.
To see this, consider Figure 3, which reconsiders the Friedman/Levitt logic under
different business model assumptions. To see how Figures 2 and 3 are linked, imagine
that the economy is first described by the straight-line business models depicted in Figure
2, where investors are choosing points along the lines connecting pure-profit and pure-
19
charity operational decisions. Then imagine that a business model innovation occurs in
each market that moves the optimal business from model A to B for charities and from
C to D for businesses.
Figure 3 about here
As Figure 3 illustrates, the original Friedman/Levitt strategy is now dominated by
operational choices for the both types of organization’s business models that lie above
the original investor allocation line. Any point above the investor allocation line is
strictly preferred to the original, “pure-charity” operational choice of the charity oper-
ating the pre-existing business model, because any of these choices offers (S, F ) pairs
that are unavailable under the old technology. Likewise, the “pure-profit” choice un-
der the pre-existing business model for profit-oriented organizations is now dominated
by new combinations of (S, F ) that are available by firms making socially responsible
operational choices under the new business model.
Figure 4 about here
This implies a new equilibrium set of investor choices as depicted in Figure 4. Instead of
instructing businesses to make purely profit-maximizing operational choices and chari-
ties to make operational choices that maximize charitable output, the new equilibrium
requires each business model to operate in a hybrid manner. Charities tilt their business
activities toward financial gain, and businesses operate in a socially responsible manner,
and investors choose an equilibrium level of S and F by picking along the outer enve-
lope of the production possibilities that are available with the new business models. As
in the analysis of the Figure 3, the optimal level of S and F can be decomposed into
two distinct social choices. The first is the optimal operational choice of each type of
business. The second is the fraction of total resources to devote to each type of activity.
20
5 Limitations and the Need for More Innovation
The analysis up to this point makes clear the fact that supply side shocks like business
model innovation must be a central element of the rising importance of CSR. But our
analysis has at least three critical limitations.
The first is that our model is completely silent on the specifics of S. While we can
all agree that F can be measured with money, a critical element required to measure the
tradeoff between F and S is labeling and measure S itself. That is, in order to measure
environmental improvement, for example, we have to be able to count the trees or lakes
that have been saved by some corporate action. This task is extremely difficult, in part
because it requires establishing a relevant counterfactual: what would the environment
have looked like if this CSR action hadn’t taken place? As de Bettignies and Robinson
(2017) illustrate, establishing a counterfactual level of S is critical to undertaking any
welfare analysis and can be extremely problematic once it is acknowledged that the
observed regulatory environment may be affected by factors like corporate lobbying.
The challenge of defining and enumerating S is part of what has given rise to new
legal forms, such as L3C and B Corporations. These have been developed specifically to
accommodate the needs of hybrid firms striving for both social and financial returns.1
That many innovations in legal form have been put forward to try to crystallize and
formalize these hybrid middle grounds illustrates that the market, too, is shy on the
specific meaning of S in any particular context.
Also, as we discussed in Section 2, there are non-trivial agency considerations that
impact how we think about CSR. In our model, investors can direct charities and busi-
nesses to behave in exactly the manner they please, but in the real-world we must be
concerned with information asymmetries and conflicting interests. For example, green-
washing is an example of misleading consumers about environmental practices. It is
1See Wexler (2009) for an overview of legal issues surrounding social enterprises.
21
important to acknowledge this limitation in our analysis.
These limitations, however, are echoed in the marketplace, where a lack of clearly
defined metrics for environmental, social and governance outcomes makes it difficult
to measure S, which in turn makes it possible for firms to engage in greenwashing and
other types of misrepresentation about CSR practices. Trelstad (2016) summarizes some
of the challenges associated with quantifying these tradeoffs and describes some of the
attempts that have been made to overcome these challenges. Both his work and our
analysis point to the need for more and better data so that investors can quantify the
tradeoffs that are an integral part of our analysis.
A final limitation is the static nature of our analysis. In particular, we are silent on
the mechanics of how business model innovation occurs. Our analysis simply assumes
that exogenous changes in business models occur, and that these changes cause shifts
in the optimal organization of the production of social goods. A more realistic analysis
would allow for the possibility that certain types of investors might “pull” organizations
to develop business model innovations that create more favorable tradeoffs.
6 Implications for Innovation Policy
Notwithstanding the empirical limitations noted above, this simple graphical analysis
nonetheless sheds light on a series of questions that are important for understanding
CSR. In this section, we briefly explore three policy areas that our analysis can illumi-
nate. First, we point out some implications of our analysis for the types of CSR that
firms choose and how CSR should best relate to a firm’s core business activities. Sec-
ond, we discuss the interconnections between CSR and social entrepreneurship that are
implied by our model. Finally, we ask how our framework can help evaluate alternative
policy strategies for regulatory actors.
22
6.1 Innovation Policy and Firm Strategy
A comparison of the business models depicted in Figure 1 suggests that the “optimal”
social cause addressed through corporate social responsibility initiatives are the ones
that have the strongest production complementarities between the S and the F activi-
ties. Thus, shoe manufacturers are better suited to address child labor initiatives than
they are supporting urban education initiatives in poverty-stricken US inner cities, not
because one is intrinsically more or less socially valuable than the other, but because the
manufacturing technology has little or no spillover effects for educating urban children.
One mechanism for such complementarity, as described above, is information asymme-
try. For example, the manager of a shoe factory in Vietnam is likely to have better
information about child labor conditions in the country than outsiders. Thus, a key
normative prescription from our analysis is that corporate social responsibility is best
directed at those causes which are most directly impacted by the normal operations
of business. This concept of complementarity has also been discussed by Besley and
Ghatak (2007), which finds that in the case of remediating “bads”, firms are often bet-
ter positioned than nonprofits, since the corporation may itself be the perpetrator of the
“bad”.
This is also consistent with how CSR is viewed by many industry observers. Many of
the examples we offered in the introduction–Patagonia, Tyson Foods, The Body Shop–
are touted as best practices precisely because they involve specific CSR activity that
is highly complementary to the firm’s core mission. Likewise, the empirical evidence
from Minor (2015) discussed in Section 2 suggests that complementarity is key to value
creation, and that CSR initiatives that lack a complementarity with the core activities
of the business in question can be perceived as disingenuous.
Similarly, a complementary prescription arises for the types of revenue generating
activities of a social organization. Commercial activities should be selected in such a
way that they are strategically aligned with the social mission. This has been noted
23
by Weisbrod (1998), who argues that commercialization of nonprofits brings financial
“interdependencies,” both positive and negative.
6.2 Innovation Policy and the Entrepreneurial Ecosystem
Another implication that arises from this analysis is that the technology frontier of the
business technology has a direct impact on the optimal level of commercialism in the
social sector, and that the nature of operations among business-oriented charities affects
the optimality of CSR in the corporate sector. To see this, consider Figure 5, which
examines the change in production possibilities associated with a change in the business
models available to charities.
Figure 5 about here
In Figure 5, the available business models for charities move upward, which means
that more S is available for any given level of F . Intuitively, if charities experience a
positive shock to their ability to transfer F into S, we should expect that the optimal
organizational plan calls for charities to produce more S and less F , while businesses
will engage in less CSR and instead produce more F . This is exactly what happens in
the framework. As business models for charities improve, the tangency line steepens,
which causes the optimal amount of CSR for firms to decrease as the optimal business
model for businesses moves closer to a “pure-F” model.
This illustrates how the opportunity cost of social business connects changes in so-
cially responsible business practice to social enterprises as well broader forces in the
economy. Or put differently, this shows how the different elements of a broader business
ecosystem are connected through a complex series of complementarities and tradeoffs. A
complementary logic would obtain if instead of the social enterprise technology changing,
the business model for corporations changed. In this case, more opportunities for CSR
24
in profit-seeking corporations would drive the tangency point for non-profits towards
more social output and less financial output. Effectively, more favorable tradeoffs for
CSR among corporations would lessen the need for non-profits to be financially viable.
When viewed through the lens of a large foundation that invests endowment income to
generate returns and then simultaneously uses those returns to support social causes,
Figure 5 illustrates the fact that as the ability of firms to behave with social responsibility
changes, this too changes the types of charities that will be supported.
6.3 A Role for Government Policy
Although there is no explicit role for government policy in our basic framework, the
structure of our analysis does offer a simple way for analyzing how alternative regulatory
strategies might work in terms of how they affect the business models that are available
to substitute between S and F . In particular, government subsidies, tax credits, and
other forms of redistribution can cause shifts in the set of business models available to
corporations and charities. Consider, for example, a government that sought to improve
domestic, inner-city labor force participation. In such a framework, S would be some
measure linked to inner-city employment, and a charity entrepreneur C might be an
agent operating a local work-force education programs. Stimulating local hiring through
an investment tax credit aimed at setting up a local factory would expand the social
output possibilities for business entrepreneurs, flattening the tradeoffs between financial
and social output.
Figure 6 about here
This logic is depicted in Figure 6, which contrasts two alternative regulatory strate-
gies towards business. A policy that restricts corporations from producing below some
critical level of S can be represented by a horizontal line, like the dashed horizontal line
in Figure 6. In contrast, a policy that subsidized the tradeoff between S and F would
25
result in a shift in the business from the straight-line business model to the one that
involves more favorable tradeoffs between S and F . This comparison captures the trade-
off that would be faced by a regulatory actor with limited resources, forced to choose
between deploying those resources to enforce compliance or spending those resources as
subsidies to spur incentive-compatible business model innovations. A complete analysis
of this tradeoff is beyond the scope of our discussion, because it requires taking a stand
on compliance costs as a function of the level of S, as well as the returns to subsidizing
innovation. However, Figure 6 makes it clear that innovation policy that improves the
corporate sector’s returns to social responsibility in many cases will have better results
than innovation policies limit corporate behavior.
7 Conclusion
Corporate social responsibility is an integral part of modern corporate strategy. Ac-
cording to the Economist, in 2014 alone the largest corporations in the UK and US
spent more than $15 billion on CSR initiatives. Whether this represents an increase
in shareholder value—doing well by doing good—whether it represents a shift in the
burden of the provision of social goods from governments to firms, or whether this is
simply another symptom of corporate governance problems is very much an open ques-
tion. A multitude of different studies have tackled these questions from numerous angles
and reached differing conclusions. As is common economics, the consensus answer is: it
depends.
One reason why understanding CSR is not clear cut is because we do not yet have
a well accepted framework for thinking about the role of CSR, social entrepreneurship,
and other organizational mechanisms that trade off social good with financial gain.
This paper attempts to offer one such framework. The framework builds from Milton
Friedman’s insight, which is that instead of a firm behaving responsibly and thereby
26
earning lower profits, it could instead maximize profits, returning the incremental profits
to shareholders who could then use these extra proceeds to support charities of their
own choosing.
The most straight-forward way of couching our analysis is to imagine a charitable
foundation that is interested in a social cause. The foundation manages a large endow-
ment to produce financial returns that allow it to keep operating into the future, as well
as use some of its proceeds to fund organizations that pursue that cause. The founda-
tion can manage its endowment with a strict goal of maximizing returns, and then plow
these returns back into charitable organizations that pursue its cause of interest, or it
can invest only in companies that operate in a socially responsible manner towards these
same causes. What investment strategy should it follow?
Once we recognize that all shareholders of a for-profit firm can effectively act as
“impact investors” on their own account, then we cannot explain the rise in CSR in terms
of shifting preferences for social output. Shifting preferences could just as easily cause
increases in contributions to endowments that support traditional charities. Demand-
side considerations can only affect the equilibrium amount of social versus financial
output in the economy, not the manner in which that is produced.
Instead, we point to business model innovation as the key to understanding the rise in
CSR and social entrepreneurship. In order for CSR to sustain the forces of competition,
it is not necessary that they increase profits. It is only necessary that CSR initiatives
trade off profits and social good at a more favorable rate than that which can be obtained
by investors and consumers acting on their own account. This alone helps to explain
the tenuous empirical relationship between doing well and doing good.
Once we recognize this distinction, a number of factors on which value judgments
about CSR depend come into sharper focus. The first is that CSR initiatives are most
likely to be welfare increasing, even if not profit increasing, if they operate at the highest
possible degree of complementarity with the core mission of the business. The second
27
is that the effectiveness of a firm’s CSR initiatives in a certain space depend critically
on what other organizations, like charities and social entrepreneurs, are already doing.
One reason why observers find little correlation between CSR and profitability in the
aggregate is that there is so much contextual variation in the degree of complementarity
and the availability of viable alternatives.
A striking implication of our analysis is that the same forces that have helped to
reshape the “business of business” have also resulted in shifting practices of non-profits,
pushing many of them to adopt business management practices that normally would be
seen in traditional startups and small businesses. At both ends of the spectrum, the key
driver of these changes is investor preferences, more specifically the ability of investors
to compel managers to act in a socially responsible manner. In terms of policy, this
in turn suggests that legal innovations in business structure that formally recognize an
organization’s dual-bottom-line objectives may actually backfire, inasmuch as they blunt
the alignment between investor preferences and an organization’s behavior.
Our analysis is also a rallying cry for innovations in reporting and data collection. The
central limitation in our analysis is that we define can only operate with a broad, “you’ll
know it when you see it” definition of social output. While this is clearly a limitation of
the analysis, it is in some sense also a reflection of an important limitation in practice:
we lack a set of well-defined and widely promulgated metrics for understanding the
output, and hence the implied tradeoffs, associated with various CSR initiatives. Many
institutional stakeholders have explicit interests in adhering to certain social principles,
but need better data to determine the tradeoffs they face. Building a robust platform
for collecting and disseminating data for measuring social output is an important next
step for the field.
28
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31
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32
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33
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34
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35
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36
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37